Chapter 1

Improving the World's Best Housing Finance System

At first glance, Louise Beyler 1 of Gainesville, Georgia, might seem to be an unlikely candidate for a mortgage to buy a $105,500 home. Self-employed and earning $19,000 a year, Ms. Beyler would have to spend nearly 45 percent of her income to cover the mortgage payments. Given her circumstances, many lenders might deny Ms. Beyler a mortgage. Thanks to automated underwriting, however, Ms. Beyler’s application was approved—in just three days.

Automated underwriting is changing the way Americans finance their homes. More and more families are discovering that obtaining a mortgage does not have to be cumbersome or frustrating. Automated underwriting also is helping people like Ms. Beyler secure a mortgage to buy a home that once seemed out of reach.

A leader in the development of automated underwriting, Freddie Mac introduced a state-of-the-art automated underwriting service, Loan Prospector, in 1995. Loan Prospector reflects Freddie Mac’s quarter-century commitment to expanding homeownership opportunities by:

• Reducing the cost of getting a mortgage
  
• Making the mortgage lending process easier, fairer and more accurate
  
• Extending access to mortgage credit to people left out of the home finance system

A History of Innovation

America has come a long way since the days when few families owned homes and fewer still had mortgages. For decades, mortgage lending was hampered by the lack of uniform loan documents and underwriting guidelines. Instead, prospective investors had to assess each loan, borrower and property individually.

In creating Freddie Mac in 1970, Congress sought to establish a reliable and efficient secondary market for conventional loans, that is, mortgages not insured or guaranteed by the federal government. At that time, Senator John Sparkman, Chairman of the Senate Banking Committee, predicted that the development of standard mortgage documents would prove to be an “historic event in home finance in America.” 2

In the early years, Freddie Mac concentrated on developing uniform documents and standardizing underwriting guidelines. This was followed by decades of important innovations, including new mortgage securities and paperless delivery of mortgages and issuance of securities. While many of these innovations are invisible to homebuyers and renters, American families reap the benefits. With each step, Freddie Mac has reduced the costs and increased the availability of mortgages.

Today, the tremendous efficiencies provided by the secondary mortgage market help make America’s housing finance system the best in the world. 3 By purchasing mortgages from lenders and selling the loans in the capital markets, Freddie Mac replenishes the funds to finance housing, ensuring a reliable supply of low-cost mortgages in neighborhoods across the country.

Eliminating Barriers to Homeownership

Despite the growth of an efficient, low-cost mortgage market, many Americans encounter significant hurdles to becoming homeowners. In 1990, Freddie Mac commissioned a ground-breaking study to identify potential barriers confronting minority and inner-city mortgage borrowers. The researchers found that secondary market underwriting guidelines sometimes were viewed as hard and fast rules, without the flexibility they were meant to have. The way lenders interpreted the guidelines may have posed barriers to community lending targeted to low-income and minority areas. 4

To address these findings and reinforce the flexibility of the guidelines, Freddie Mac brought together community lenders, real estate professionals and housing advocates to study secondary market underwriting practices. Their mandate was to identify and suggest ways to eliminate potential barriers to homeownership. Later formalized as Underwriting Barriers Outreach Groups, they continue to provide Freddie Mac with valuable insights into the underwriting process.

Based on the recommendations of these groups, we have revised more than 40 different sections of our underwriting guidelines to provide greater clarity for lenders. To reinforce the message of underwriting flexibility, Freddie Mac has conducted hundreds of training sessions and created and distributed an underwriting guidebook, Discover Gold Through Expanding Markets. This booklet features more than 100 case studies illustrating the flexibility available to lenders when evaluating more difficult loans.

Revamping Traditional Underwriting

At the same time Freddie Mac was clarifying underwriting guidelines, the company undertook a more ambitious project: to redesign the mortgage underwriting process itself through the development of more fact-based tools to predict loan performance.

Although an early entrant in the automated underwriting field, Freddie Mac was not the first to create a system for providing computerized evaluations of loan applications. 5 Mortgage insurers, as well as lenders and others in the mortgage industry, had developed their own automated systems, employing varying solutions to the underwriting challenge.

Some chose approaches that simply converted existing underwriting standards to an electronic format. While these “rules-based” systems speed up the underwriting process, they do not improve the accuracy of lending decisions.

To offer a better approach, Freddie Mac worked with industry partners to create an underwriting system based on the repayment experience of actual loans. This system is built on a sophisticated analysis of which loan, borrower and property characteristics, together and in combination, affect mortgage performance.

To produce the statistical basis for Loan Prospector, we began by combing our extensive database to develop a geographically, economically and demographically diverse sample of mortgages. The sample consisted of more than 200,000 loans, each with an established repayment record spanning several years.

Using this sample, augmented by other data, Freddie Mac was able to pinpoint key factors that cause loans to default, along with their relative importance. We also were able to quantify complicated trade-offs so that strengths in a loan application could offset weaknesses. We then tested the statistical results against the actual performance of millions of other loans, verifying the accuracy of the system.

In 1994, Freddie Mac enlisted a small group of lenders to test the new automated underwriting service under real-world conditions. By conducting second-look manual reviews on virtually every loan application evaluated under the pilot program, we confirmed that the system was working as intended. In February 1995, Loan Prospector became commercially available to all Freddie Mac lenders.

With Loan Prospector, Freddie Mac is extending a 25-year record of reducing mortgage costs and bringing the benefits of the secondary market to more American families. In short, we have built a statistically driven, automated underwriting service to help lenders make accurate and fair credit decisions with previously unattainable precision and speed.

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